What is the Rates Market Telling Us?

The rates market interprets the recent breakdown in U.S.-China trade negotiations and risk of tariffs with Mexico as a signal that growth, and therefore inflation pressures, will be slower and lower than previously expected.

17.06.2019 | 13:45 Uhr

This
is true not only in the U.S., but globally as well, and the decline in
U.S. yields and flattening of the yield curve are both logical price
adjustments to this new information.

Explaining the decline in yields

We think about bond yields as a mechanism that discounts the path of
short-term interest rates, in order to estimate the level of longer term
bond yields. There are four main components to the mechanism and what
follows is the current status of each:

Growth outlook:lower/declining due to trade related concerns

Inflation outlook:lower/declining due to pressure on global growth, i.e. oil and commodity prices

Central bank outlook:dovish

Term premia:falling
due to all of the above, i.e. investors in longer maturity bonds are
demanding less risk compensation for rising inflation risks

Given that all four components are pointing toward lower yields, our
framework leads us to conclude that rates may fall further, where a 2.00% yield for the U.S. Treasury (UST) 10-year would not be unreasonable.
However, we are careful to specify this is the current status, which
means economic conditions could get better or worse and change the
expected level of long-term bond yields.

What the flattening of the UST yield curve means

The market broadly agrees that a flattening, and especially an
inversion, of the yield curve is an indication of recession risk.
However, there is notable disagreement on the strength of this signal.

As we see it, the signal strength is weak. Why?
Because historically the yield curve has inverted when the U.S. Federal
Reserve (Fed) was in a process of TIGHTENING, i.e. intentionally raising
rates too high in order to slowdown an overheating economy and contain
inflation from rising well above target.

We cannot emphasize enough that this is NOT the case today.
The Fed has not tightened, they have simply removed excess accommodation
and moved to neutral. The yield curve is flattening because investors
currently believe growth and inflation are less likely to accelerate in
the future. Therefore the risk premia, aka term premia, of holding
longer maturity bonds have fallen dramatically. We believe this explains
why longer term yields have fallen and the yield curve subsequently
flattened.

We think the yield curve today represents weak signal strength for a
recession, but a strong signal for slower growth and inflation. To the
extent that slower growth and inflation increase the probability of
recession, it is valid to currently attribute some coincident connection between curve flattening and recession risk, with the understanding that it is not a causal relationship.

Investment Strategies:

Growth is slowing, not collapsing. This means the risk of a recession remains low, thus default risks also remain low